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Monday, September 6, 2010

U.S. defense industry girding for predicted slump

After years of predictions of a downturn that never materialized, U.S. defense companies are now bracing in earnest for leaner times, lower profit margins and tougher negotiations about government contracts.

Defense Secretary Robert Gates has launched a major efficiency drive to trim $100 billion out of the Pentagon's bloated overhead accounts from 2012 to 2016 to help avert cuts to modernization programs or funding for troops.

The Pentagon insists it expects to get growth of 1 percent after inflation in its overall budget in the fiscal 2012 budget request, despite cuts expected in other government accounts.

But much of that will be eaten up by rising personnel and health costs, leaving far less money for weapons programs than during years of double digit growth in defense spending after the September 11, 2001, hijacking attacks.

That has left industry executives with a growing sense of apprehension about the future, especially given the end of combat operations in Iraq and yawning deficits that have even some normally hawkish Republican lawmakers calling for cuts.

For a graphic on defense companies' sales and profits, please see link.reuters.com/vew39n

"The contractors are finally waking up and realizing that Gates is serious," said Jim McAleese, a Virginia-based defense consultant, adding he did not foresee big program cancellations until the fiscal 2013 budget cycle, which begins next spring.

The Pentagon's efficiency and acquisition reforms are pressuring companies across the industry to make their organizations leaner and sell off unprofitable units. Many will also have to accept more risk and lower profits on the shrinking number of defense contracts that are up for grabs.

Across the board, prospects for flat defense budgets have prompted companies to step up overseas arms sales, hunt for attractive acquisitions and move into adjacent markets.

Executives from the largest defense companies will map out their strategies for weathering the storm at the annual Reuters Aerospace and Defense Summit in Washington next week.

GRAPPLING WITH SOFTENING DEMAND

"Everybody in the sector knew that one day there would be a downturn. Now it has finally hit the industry and companies are determining what concrete steps they must take to deal with softening demand," said Loren Thompson, chief operating officer of the Virginia-based Lexington Institute.

Recent news of delays in the U.S. Army's multibillion-dollar ground combat vehicle program and an even bigger U.S. Navy warship program -- two of the few new Pentagon programs out for bidding -- deeply unsettled industry executives.

The U.S. Air Force still plans to award a new refueling plane deal valued at up to $50 billion to either Boeing Co (BA.N) or its European rival, Airbus parent EADS (EAD.PA), this fall, but says that could mean a deal as late as mid-December.

And the Pentagon has taken months longer than expected to finalize a contract with Lockheed for the next batch of F-35 fighters, evidence of the tighter scrutiny being given to any contracts amid the Defense Department's new war on waste.

MINING THE BACKLOG

Thompson said most companies have a solid backlog of orders from Bush administration years that would last for some time, although many companies are now trying to "mine the backlog," and get more out of the orders they already have.

That means layoffs, tougher negotiations with suppliers and customers, and efforts to cut expenses across the board.

Some companies like Lockheed Martin Corp (LMT.N) and Northrop Grumman Corp (NOC.N) have already taken more strategic steps to adjust their portfolios and sell off units that weren't a good fit in the current budget environment.

Others that played a big role in supplying vehicles for the Iraq and Afghanistan wars, like BAE Systems (BAES.L), Oshkosh Corp (OSK.N) and General Dynamics Corp (GD.N), could face some headwinds, as could companies that were heavily dependent on big military networking programs that are going out of vogue.

Mergers and acquisitions activity is expected to pick up, given low valuations, ample cash reserves and the industry's need to continue generating growth for shareholders.

"Last year we were saying 'Flat is the new up.' This year and next, the headline is, 'M&A is back,'" said Tom Captain, global aerospace and defense sector leader for Deloitte LLP.

Defense stocks have declined 1 percent so far this year and could face further downturns in coming months, analysts say, although they note the November U.S. congressional elections or a major extremist attack could dramatically change the story.

Richard Aboulafia, vice president of the Virginia-based Teal Group, said defense stocks still represented a refuge for investors, given mounting fears about a double-dip recession.

"Defense companies would be in serious trouble if the economy weren't so uncertain. It's a safe haven compared to what else is out there," he said, adding "It's as close as you can get to guaranteed returns."

But he said many lawmakers appeared to be suffering from "defense spending fatigue" and it was uncertain how long the Pentagon would be able to maintain a steady budget topline, given the fact that Gates is already flagging his retirement.

Lawmakers are still willing to fight for some programs, like the second Lockheed F-35 fighter engine, being built by General Electric Co (GE.N) and Britain's Rolls Royce (RR.L), a program Gates has tried repeatedly to kill.

GE and Rolls are fighting hard to maintain the contract and avoid handing Pratt & Whitney, a unit of United Technologies Corp (UTX.N), a monopoly stake in an engine market valued at around $100 billion over the longer term.

Even if the budget does decline somewhat and profit margins come down from current rates around 10 to 12 percent, Aboulafia said the overall level of defense spending would remain high. "You're still talking about an awful lot of money and relatively low risk in an economy with relatively few robust opportunities," he said.

As defense companies face tamer growth, their commercial counterparts are poised to benefit as air traffic improves from the two-year downturn and production of Boeing's 787 Dreamliner plane ramps up.

"We're going to see three, four, five years of considerable topline growth and that will benefit not only Boeing's earnings but earnings and revenues for the suppliers," said Paul Nisbet, an analyst with JSA Research and longtime aerospace watcher.

"The commercial side from all indications, if we don't have a real bad world economy, is in for some very good years."